Streetwise Professor

A few days ago the WSJ reported that US securities exchanges are close to upgrading one of the Securities Information Processors, the part of the RegNMS market structure that links the various exchanges.  The SIP consolidates and disseminates quote data from the various exchanges.  It provides the linkages that are necessary for the links-and-information structure created by RegNMS.

The SIPs have been a source of chronic complaints in the industry.  The current fix was compelled by a breakdown in the SIP over the summer that caused a shutdown in trading of some stocks.  But even when the SIPs work, they disseminate information more slowly than the private connections between exchanges and HFT firms.  This gives an advantage to HFT traders.

The WSJ story indicates that the operating system of the SIP is obsolete.

This issue illustrates an inherent problem with a utility-type model in securities markets. I discussed this problem in my research in the late-90s and early-00s, including in a JLEO article that was published in 2002.  That research was focused on a CLOB model, but the same issue is relevant for a the current SLOB (Simulacrum of a Limit Order Book) model. Specifically, a utility CLOB (or SLOB) has strong public good aspects.  All market participants benefit from better technology and improved performance, but would prefer that others pay for it.  Collective action and public goods problems tend to lead to under provision of quality and technological improvement.

SIPs are industry public goods, and face the same problems.  No wonder they are obsolescent.

There are other problems with the linkages approach that undermine incentives to  invest in SIP quality and technology.  The whole idea behind the linkages approach is to facilitate competition between exchanges.  But exchanges have no incentive to facilitate competition between themselves.  Competition is likely to be weaker with a kludgy linkage system, so why should exchanges push to improve it?  Not to mention that some interests, notably HFT, which would face a diminished competitive position with  more advanced SIP, also have an incentive to impede updates.

This is an inherent challenge to the linkages approach.  Its effectiveness depends on, well, the technology that links markets.  But the incentives to invest in those linkages are suboptimal due to the public good problems, exacerbated by the fact that competing exchanges don’t have an incentive to intensify competition between them.

But as I’ve often written, the alternatives have their own problems.  Most notably, if you don’t mandate linkages between markets, order flow network effects tend to cause the dominance of a single exchange.   So you need linkages and socialization of order flow if you want competition, but there will be underinvestment in the linkages.

US securities markets are committed to the linkages approach.  Public goods problems that provide inefficiently weak incentives to invest in the links necessary to make the approach work mean that it will be beset by chronic difficulties.